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May 4, 2012

PIMCO’s El-Erian: A Global Realignment Our Grandchildren Will Talk About

The CEO of the bond giant PIMCO, which has $1.3 trillion in assets under management, quoted Fed Chairman Ben Bernanke when saying, “We are living in unusually uncertain times.”

“I am going to start with Europe, but not talk about it specifically,” he said. “Rather, I am going to use Europe as a prism through which to view the world and our industry.”

He then posed three hypotheses. The first is that Germany’s outlook cannot be divorced from Europe or the world in general and vice versa, “they are incredibly interlinked.” The second is that progress on the crisis is undermined by a lack of common analysis and vision. The third is that, as a result, we are in a world of “third- or fourth-best [solutions], as opposed to first.”

He then turned to five discussion points for the remainder of his presentation.

What lies at the heart of Europe’s trouble?

How have policymakers responded?

We must evaluate Germany as the “good house in a bad neighborhood.”

What are the global parallels to the European crisis?

What are the implications for how we should invest?

El-Erian addressed the first point by noting that Europe, with the exception of Germany, has essentially not grown in 12 years. While Germany has managed to stay ahead of the rest, the other countries are less competitive as a result of the “retrenchment” the euro zone is currently experiencing.

“They’ve accumulated debt in all the wrong areas; meaning in the weak euro zone areas as opposed to the strong,” he added. “They have too little growth, too little competitiveness, too much debt and debt that has been applied to the wrong areas.”

The policymakers’ response was to go from “denial to political and policy catch-up to the gradual emergence of a more holistic approach through four interrelated components.” The four components are:

Getting the growth and austerity mix right (Europe is not yet there)

Protect the outer periphery countries as well as the inner core

Strengthen the core by “re-founding” Europe

Build a bridge to prosperity through the use of liquidity

“Europe understands this list now, but the implementation of its components lags,” El-Erian said. “It went from stable to ‘bimodal’ with fat tails. What will Europe be in a year? There is a high probability there will be a re-founding of Europe using the West and East Germany as a model. There is a lower probability it will fragment. If that happens it will be a total mess for Europe and the world. But it will tip one way or another and either way will be bumpy.”

The United States is a house in their neighborhood, and therefore Americans should be concerned, he continued.

“Germany needs a partner, which is one reason you see a German chancellor actively campaigning for a French president. That is very unusual but they have a good relationship; basically, Merkel makes the decisions and Sarkozy explains them to the world,” he quipped to laughter from the audience.

As far as the fourth point, the parallels between Europe and the rest of the world are:

The robustness of the U.S. economy is facing structural impediments to growth

The U.S. policy response from the Fed is “tactically smart” but strategically short-sighted

There is a large and growing dependency on policies that fundamentally change the functioning of the markets

Outer countries in many other parts of the world are not willing to move to the center

There is a question of how the global economic system will evolve from here.

He concluded with the implications for investing, which he called the “Great Escape.”

“In the short term, investors must escape the world of deleveraging. They must stay in the game as others try to pick their pockets in the market.”

Comparing investors to Muhammad Ali’s strategy for beating George Foreman in the “Rumble in the Jungle,” he said investors must be able to absorb market blows and be agile enough to react quickly.

“We are living in a global realignment that our children and grandchildren will be talking about. We can’t see it, because we are so close to it, but make no mistake, it’s there.”